Risk Management Basics
- Derivatives Basics
- Put-Call Parity
- Forwards vs Futures
- Spot Rate
- Forward Rate Formula
- Cash Settlement vs Physical Settlement
- Backwardation vs Contango
- Residual Risk
- Best Futures Books
- Futures vs Options
- What are Options in Finance?
- Exercise Price (Strike Price)
- In the Money
- Options Trading Strategies
- Call Options vs Put Options
- Options vs Warrants
- Writing Call Options
- Writing Put Options
- Gamma of an Option
- Options Trading Books
- International Option Exchanges
- Interest Rate Derivatives
- Interest Rate Swap
- Swap Rate
- Random vs Systematic ErrorÂ
- Equity Strategies
- Swaps in Finance
- Embedded Derivatives
- Commodity Derivatives
- Commodity Risk Management
- Managed Futures Strategy
- Top 7 Best Books on Derivatives
- Structured Finance Jobs
- Commodities Trading Books
- Best Commodities Books
Differences Between Backwardation and Contango
Is this English in the first place? Why such crazy names? Don’t ask me these questions. I was forced to learn this stuff because it was named so and was part of my syllabus. Just accept this and move on. The good part is that these words make you sound like an intellectual star in the world of derivatives, especially commodity futures. So let’s get to it!
- What are Futures?
- What is Contango?
- What is Backwardation?
- Why does a Contango or Backwardation happen?
- Conclusion – Backwardation vs Contango
What are Futures?
Before getting into understanding these terms, we need to have an idea about futures markets and corresponding contracts. A ‘futures contract’ is a standardized contract traded at an established exchange to buy/sell an underlying asset at a predetermined point in time in the future. So, today I might enter into a futures contract to buy/sell 10 oz. of gold (the underlying) at a price (the futures price) of $1350/oz. on September 10th 2016. So, irrespective of what the price of gold may be on that date, we have the obligation to buy/sell gold at $1350/oz. on that date. [When we enter the contract to buy the underlying we take a ‘long futures’ position and we take ‘short futures’ position to sell the underlying]
Why do you buy futures contracts?
The answer is simple – to get a good sleep at night without worrying too much about the price movements since you have fixed the price at which you’re going to buy/sell the underlying. In the earlier example, if you entered into a futures contract to buy the underlying and the underlying’s price is greater than $1350/oz. on September 10th, you stand to gain and if it’s lesser than that, you stand to lose. The opposite is true for the seller of the futures contract.This gain or loss is an opportunity gain/loss since we assume that you are going to take delivery/make delivery of gold on expiration of the contract (Sep 10th).This is considered to be ‘hedging’.This could also be cash settled. If cash settled, then we can sell/buy the underlying in the spot market at that time and realize our gains.
Delivery of the Underlying
On the other hand you might buy/sell exactly the same contract but without the purpose of taking/making delivery of the underlying in which case you might sell/buy the futures contract (reverse the initial position taken in the contract) before the date of expiration so as to close out your position – terminate the contract. This could be considered ‘hedging’ but depending on the purpose more often than not, it is ‘speculation.’ Here the contract is settled in cash for the difference between the entry and exit price of the futures’ contract on the date of contract termination depending on the initial position taken. So, I may reverse my long/short futures’ position on gold at the future’s price on say, Sep 7th which might be $1360/oz. while. You can calculate the gain/loss depending on the initial position taken which is scaled by the futures multiplier (forget that for now).
If you want to continue holding the same position which you held at contract initiation even after it expires, you can roll over the contract by reversing the initial position and entering into a new contract preferably before expiration due to certain reasons.
Since futures contracts try to remove counterparty risk (exchange traded), there are margin requirements in place. Next, there are multiple futures prices which are based on the different contracts. For ex, the June Contract Futures Price might be different from the September Contract Futures Price which might be different from the December Contract Futures Price. But, there’s only one Spot Price always.
Another important aspect to keep in mind is that as the futures contract approaches expiration, the spot price/market price and the futures price converge and both are equal at contract expiration, not termination – remember the difference. This is also known as the ‘basis convergence’ where basis is the difference between the spot and futures price.
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Finally, there are three types of contracts –
- near month (front month);
- next month (back month);
- far month.
If you still haven’t got the hang of all the above, you can google it out and get back to this.It isn’t easy to teach almost everything about futures in a page along with examples you know! After a few tough paras you’ve gone through here’s some more fun. Let’s get back to the original topic. Read the following content slowly and picture it in your mind.
The Concepts first
What is Contango?
When the Spot Price of the underlying (St) is lesser than the Futures Price (Ft) at a particular point in time, the situation is called ‘Contango’. So, if Brent Crude is at $50/barrel now (June 1st)and the futures price i.e., price of the front month futures contract on Brent Crude today is $55/barrel (the futures price for 27th June on June 1st is $55/barrel), the Brent Crude Contract is said to be in Contango. The spot and futures prices move the way they are supposed to, driven by demand-supply, news etc. but at the expiration of the contract, the futures price and the spot price are the same. Contango is actually with respect to a particular date and contract. I hate to say it, but it’s become a popular notion to say that the market is in Contango in this case, Brent Crude. The June Contract may be in a Contango, but the July Contract may not. The market is in Contango if all the futures contracts with different expirations have prices higher than the spot price.
Contango occurs when St< Ft i.e., Spot Price at time ‘t’ is lesser than the Futures Price at time ‘t’. The futures price could be that of the June or September or December contract for example. In the above, it is with respect to June.
The June contract is said to be in Contango in this case
The market is said to be in Contango in this case since all the contracts’ futures prices are higher than today’s spot price
This isn’t visible. This occurs when the ‘Expected Spot Price is lesser than the Futures Price (E[St]< Ft). It is either a model based curve or an imaginary curve. It is a function of expectations which is an average coming out of probabilistic outcomes. With reference to the above graph, if on June 1st, you expect the Spot Price on 27th to be less than $55/barrel, then it is considered to be Normal Contango as the Futures Price on June 1stfor June 27this $55/barrel. We’ll keep this concept out of the picture. It’s just extra information so that you know the difference between Normal Contango and Contango.
What is Backwardation?
When the Spot Price of the underlying (St) is greater than the Futures Price (Ft) at a particular point in time, the situation is called ‘Backwardation’. So, if Brent Crude is at $50/barrel now (June 1st) and the futures price i.e., price of the front month futures contract on Brent Crude is $45/barrel today(the futures price for 27th June on June 1st is $45/barrel), Brent Crude is said to be in Backwardation. The spot and futures prices move the way they are supposed to, driven by demand-supply, news etc. but at the expiration of the contract, the futures price and the spot price are the same. Here too, Backwardation is also with respect to a particular contract on a particular date. Again I hate to say it, but it’s become a popular notion to say that the market is in Backwardation in this case, Brent Crude. The June Contract may be in a Backwardation, but the July Contract may not. The June Contract may be in a Backwardation, but the July Contract may not. The market is in Backwardation if all the futures contracts with different expirations have prices higher than the spot price.
Backwardation occurs when St> Ft i.e., Spot Price at time ‘t’ is greater than the Futures Price at time ‘t’. The futures price could be that of the June or September or December contract for example. In the above, it is with respect to June.
This isn’t visible. This occurs when the ‘Expected Spot Price is lesser than the Futures Price (E[St]>Ft). It is either a model based curve or an imaginary curve. It is a function of expectations which is an average coming out of probabilistic outcomes. With reference to the above graph, if on June 1st, you expect the Spot Price on 27th to be more than $45/barrel, then it is considered to be Normal Contango as the Futures Price on June 1st for June 27th is $45/barrel. We’ll keep this concept out of the picture. It’s just extra information so that you know the difference between Normal Backwardation and Backwardation.
Why does a Contango or Backwardation happen?
One obvious reason is excessive demand or oversupply either for spot asset or futures causing Contango or Backwardation depending on the case.
- Cost of carry (c): Afancy sounding word which simply means the costs to holding the underlying asset with you. Don’t you put important documents in a bank locker for example? You are probably afraid that rodents may eat into them or you may lose them or for whatever reason. Same is the case with commodities. You may prefer not buying the underlying asset right now since you’ll have to bear with the costs of storing it, say in a warehouse or locker or whatever! This reduces the demand for the asset in the spot market thus lowering the spot price and increases the price of buying the asset in the future (futures price) by this cost. This could also lead to shortage in storage capacity increasing its carrying cost. It can be converted in terms of a yield (%).\
- Rate of interest (r): Postponing purchase of the asset in the spot market because of going long the futures contract keeps you with more cash which is assumed to be earning interest (at the risk-free rate) till the asset is purchased in the futures market. So, the spot price compounds at the rate of interest till the asset is purchased in the future which gets reflected in the current futures price.
- Convenience Yield (y): An industry or big companies may feel that there is going to be a shortage of a commodity, say ‘oil’. Thus they indicate starting to increase their stockpile of oil barrels now rather than doing it in the future. They do not sell existing oil barrels in the fear that they may not be able to buy it in the future as it might be in shortage. This mood and momentum pushes the Spot Price up and lack of demand in the futures market pushes its price down relative to the spot. This is a ‘fear premium’ embedded in the spot price.
How does it become a yield?
Due to the fear of perceived future shortage, they don’t sell the asset as they may use it for production etc. Note that it starts looking like an income producing asset although it doesn’t produce income!
S0 = $50/barrel
T = 1 year
r = 10% p.a. continuously compounded
Theoretically, the Futures Price given the above information should be $55.26/barrel i.e.,
50 × e^((10%)×1)=55.26
But the actual futures price is $52/barrel. It looks like a Contango and an arbitrage play but because of the fear the equation turns around to become:
52= 50 × e^((10%-y%)×1 )
Using logs, we get
Thus, the equation governing the Futures Price with respect to the Spot Price is as follows (when it is continuously compounded as is the convention)
F”t”= S”t” × e^(( r+c-y)×(T-t))
Ft – the Futures Price at time ‘t’
St – the Spot Price at time ‘t’
r – risk-free rate of interest
c – cost of carry
y – convenience yield
(T-t) – days to expiration from the date of pricing ‘t’ to the contract expiration date ‘T’
Conclusion – Backwardation vs Contango
Looking for real-life examples are you? Observe how oil has moved from beginning of 2014 till today. Look at the spot prices and the futures prices and observe the moments when the market was in a Contango or Backwardation. No further explanations but I will just introduce you to an advanced concept and leave it at that!
- For the initial long futures position holder, in general Backwardation leads to a positive roll-yield and Contango leads to a negative roll-yield.
- For the initial short futures position holder, in general Backwardation leads to a negative roll-yield and Contango leads to a positive roll-yield.
Once you get familiar and do further reading on Contango and Backwardation, you should ideally come across the above. Think about why it happens! If this article has made your taste buds for derivatives dry up, take time to recoup, read this once again, get familiar and then go ahead with further reading!